Given high uncertainty on the persistence of inflation, staff
recommends maintaining a tight monetary policy stance until there is
firm evidence that inflation is on course to converge to target.

Although the policy rate has remained unchanged since June 2022, recent
decreases in inflation and its expectations have raised the ex-ante real
policy interest rate and tightened the monetary policy stance. Given
heightened profit shares the ongoing recovery in real wages can be absorbed
by firms without adding significant upward pressure on prices, allowing the
disinflation to continue. This will require, however, aggregate demand to
remain contained. In the absence of sharp downside surprises in inflation,
staff advises to maintain a tight monetary policy stance—by keeping the
nominal policy rate broadly unchanged through early 2024—to consolidate the
disinflation process and provide insurance against a costly de-anchoring of
inflation expectations. Thereafter, the nominal policy interest rate could
be lowered cautiously and gradually, consistent with the decline in
inflation, with a pace that could be accelerated if inflation expectations
align faster to the target than envisaged. Given high uncertainty around the
path of commodity prices, wages, profits, and inflation, a data-driven,
meeting-by-meeting approach to determine the interest rate path remains
essential.

• Fiscal Policy
• 
  Fiscal plans for 2024 appropriately emphasize consolidation, but
  fiscal policy should remain flexible given the uncertain outlook.
  
  In cyclically adjusted terms, staff projects the fiscal deficit to
  contract by 1.3 percent of potential GDP. The contractionary stance is
  appropriate to support disinflation efforts, with the output gap set to
  nearly close in 2024. However, given uncertainty on the growth outlook,
  it is prudent to allow automatic stabilizers to operate.
  
  
• 
  Over the medium-term, fiscal policy is guided by Czechia’s fiscal
  responsibility act (FRA), which sets a minimum fiscal consolidation
  path that delivers a sustainable debt-to-GDP ratio and a low
  prudent fiscal balance.
  
  During the pandemic, fiscal balances were allowed to deviate from the
  medium-term objective (MTO) in the FRA, with a clear fiscal
  consolidation path back to target. In line with this, staff’s baseline
  envisages a debt-to-GDP ratio of 42.5 percent and a structural balance
  of -0.8 percent of potential GDP by 2028, which is consistent with the
  MTO—a structural balance of -0.75 percent of GDP. Czechia is at a low
  overall risk of sovereign stress; hence, reaching the MTO by 2028 will
  contribute to keeping debt sustainable over the medium term. The
  November 2023 fiscal outlook identifies measures through 2025 but
  reaching the MTO would require identifying additional measures.
• 
  In the medium and long term, spending pressures will increase to
  facilitate economic transformation toward a green digital economy
  and address the impact of population aging.
  
  The economic challenges of global technological shifts and population
  aging calls for structural reforms, investments, and efforts to ease
  the reallocation of labor and capital. The structural transformation
  may entail a heavy burden on some segments of the population, requiring
  social safety net support. Public sector infrastructure will need to be
  adapted to accommodate clean energy initiatives and digitization. To
  ensure a skilled workforce aligned with emerging activities, active
  labor market policies (ALMP) and ongoing education system reforms will
  be imperative. The aging population will give rise to a pension funding
  gap in the long-term. For intergenerational fairness and to avoid
  disruptive fiscal adjustments, the actuarial deficit of the pension
  system would call for higher general government structural balances
  than the currently targeted MTO. Also, an additional buffer is
  warranted to protect against future shocks and fiscal risks.

Although EU funds will cover part of the forthcoming spending
pressures, additional fiscal measures will be required.

These should include growth-friendly tax measures, reprioritization of
spending and improved spending efficiency. Staff recommends the following
measures:

• 
  As the recovery takes hold, ensure that the Personal Income Tax
  (PIT) and real estate related taxes deliver pre-pandemic tax
  revenue as a percentage of GDP.
  
  This would yield above 1.5 percent of GDP. It is crucial to note that
  the reduction of the PIT was originally presented as a temporary
  measure.
• Further advance pension reform. Staff welcomes recent
  regulatory reforms to the pension system. These initial steps need to
  be complemented with additional reforms to improve the long-term
  sustainability of the pension system, including the linking of
  retirement age to life expectancy.
• Macroprudential and Financial Sector Policies
• 
  The macroprudential policy setting is broadly adequate but the
  deactivation of the debt-service-to-income ratio should be
  reconsidered.
  
  Estimates of the financial cycle suggest the partial release of the
  Countercyclical Capital Buffer (CCyB) was justified. Staff also supports
  maintaining the Loan-to-Value (LTV) and Debt-to-Income (DTI) ratios at
  current levels, as the implementation of borrower-based measures has
  contributed to responsible lending practices and lowered the systemic
  risk in the banking sector. Although the increase in policy rates and
  its transmission toward lending rates made the Debt-Service-to-Income
  (DSTI) levels more binding, deactivating the DSTI allows banks to
  provide potentially riskier loans from a DSTI perspective.

  Staff therefore recommends reinstating this instrument, and going
  forward, recalibrating and improving its design, including by
  legislative changes, rather than its deactivation and reactivation.

Staff assesses that the banking sector is broadly resilient.

Financial sector indicators point to a well-capitalized, liquid, and
profitable banking system compared to its European peers. Staff welcomes
the improvements in supervisory risk measurement for sectoral/ individual
exposures and reiterates the importance of further progress in this area.
However, pockets of vulnerability remain and require close monitoring.

• 
  The risks associated to the increase in the euroization of
  corporate loans need to be carefully scrutinized.
  
  Staff welcomes the incorporation of these risks into the CNB’s
  financial stability analysis, and the capital requirements on risks
  associated to banks’ FX positions. Although stress test results suggest
  that these risks are not systemically important, close monitoring of
  the credit, exchange rate, and counterparty risks, including in
  derivative transactions, are warranted.
• 
  Since the pandemic, the banking sector’s direct risk exposure to
  the Treasury increased but remains contained.
  
  While sovereign risk is low and not expected to change, exposures need
  to be monitored.
• 
  Although risks from real estate exposures have diminished
  substantially, they require continued monitoring.
  
  The evolution of loan quality over the cycle, and possible
  nonperforming loans down the line, should continue to be managed.
• Structural Policies